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Firms that offer CFD products could do better, says British regulator

Chris Hamblin, Editor, London, 23 February 2016

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The UK's Financial Conduct Authority is worried that firms that offer products relating to contracts for differences might be mis-categorising HNW customers as professional rather than retail.

In a survey of ten firms large and small, the FCA found that eight were classifying customers as retail, thereby giving them the highest standard of protection against sharp practice, but two were not. In a recent 'Dear CEO' letter to firms that offer CFD products, the regulator went on: "it appears that firms may not have processes that allow them to assess the appropriateness of CFD trading for prospective clients, which could result in firms failing to identify clients for whom CFDs are not appropriate. We were also concerned to find that firms’ communications did not meet our expectations. As an example, risk warnings given to clients did not convey in a clear and fair way that the product was not appropriate for the customer."

The FCA counts all contracts for difference, spread bets and ‘rolling spot’ FX as a type of CFD, which is a type of derivative that is attractive to high-net-worth investors who like to speculate. When Mr A sells Mr B an asset, Mr B does not pay him. Instead, Mr A pays Mr B the difference between today's price and the price at contract time. If the price goes down, Mr B pays Mr A the difference. This is what Mr A is hoping for - essentially, both parties are gambling.

The main reason for this rough-and-ready sample was to take stock of client take-on procedures in the context of the FCA's conduct-of-business (COBS) and systems-and-controls (SYSC) rules. Most 'appropriateness' assessments were not in line with COBS 10, which applies to firms that provide investment services in line with the European Union's Markets in Financial Instruments Directive (personal recommendations and managing investments excluded).

Also regarding COBS 10, many firms did not gather enough detailed information about the types of service, transaction and investment with which their customers were familiar and they did not look at their customers' previous transactional experience. They craftily gave excessive weight to irrelevant details such as clients' age and length of time at address when estimating their clients' knowledge and experience - indeed, the FCA believes their eventual guesses to be meaningless.

Another 'dodge' was to sidestep the requirement in rule 10.2.1(2)(a) to  determine whether the client has the necessary experience and knowledge in order to understand the risks involved in relation to the product or service being offered or demanded, merely asking clients to tick a box to say that they understood the risks. The point of this was to benefit from 10.2.1(2)(b), which allows firms to assume that professional clients have enough experience and knowledge to understand the risks. Everything must happen in the context of rule 10.2.1(1), which obliges firms to ask clients for real information about their knowledge and put some real effort into assessing the 'appropriateness' of investments.

Firms also neglected to gather the kind of information dictated in detail by rule 10.2.2, i.e. the types of service, transaction and investment with which clients are familiar; the nature, volume and frequency of their transactions to date; and their professions or relevant former professions and/or standard of education to do with investments.

A stone's throw away from 10.2.2 (although not mentioned in the 'Dear CEO' letter) is rule 10.2.3, which bans every firm from encouraging its clients not to provide information required for appropriateness. Did any relationship manager tell his client that it was all right to tick the box because he seemed to have enough experience? We shall never know because the FCA seems not to have quizzed any customers as part of its enquiry. Next time things might be different.

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